The Sterling Ratio Explained

Sitting here five years from the March 2009 lows in the stock market, it can be easy to forget just what makes alternative investments appealing for many investors. It isn’t the top line performance such as we’ve seen in stocks recently, more often than not it’s the risk adjusted performance.

The most popular (and overused) risk adjusted performance metric is the Sharpe Ratio, but the investment world is littered with many more of these tools for comparing different investments and asset classes to one another on how much return they earn per unit of risk. The risk part is what changes in these metrics, with the Sharpe seeing risk as volatility, the Sortino as downside volatility, or the MAR by maximum drawdown.

Enter the Sterling Ratio, which measures return over average drawdown, versus the more commonly used max drawdown – which is the largest peak to valley loss experienced over the entire track record. While the Max Drawdown looks back over the entire period you’re analyzing and takes the worst point along that equity curve, a quick change of the look back allows one to see what the worst peak to valley loss was for each calendar year as well. From there, we can average the drawdowns of each year to come up with an Average Annual Drawdown.

Sterling Ratio = (Compound ROR) / ABS(Avg. Ann DD – 10%)

Some versions of the Sterling may also subtract the risk free rate (although it has been effectively 0% for the past 5 years, making it a moot point); giving investors a ratio of the average annual return over the average annual drawdown (less that 10%). Ideally that number would be greater than 1, so you are getting more reward for the risk taken each year, and the higher the better.

Now what the heck is that arbitrary -10% in there for? It’s sometimes listed as a positive number, too? Let’s first say, the result of the equation should be a positive number, so if you are putting in your drawdown as a negative number, then subtract the 10%, and then multiply the whole thing by a negative to result in a positive ratio. If putting the drawdown in as a positive number, then add 10% and your result is the same positive ratio.

There’s not much documentation on why the 10% is in there, or even what the original definition of the Sterling Ratio is – but our take is that the average drawdown over a typical 5 year period can be quite small (just look at stocks the past 5 years), and therefore a sort of ‘reality adjustment’ is needed. Another possibility may be that the ratio would break (divide by zero error) if there were no drawdowns over the period, so the formula included the arbitrary number to insure there was always something in the denominator.

A better ratio would have a ‘reality adjustment’ factor tied to the program’s volatility or some other sort of metric based on the program’s data instead of just picking 10% out of thin air. Imagine program’s which target drawdowns of less than 10% don’t like that number much, as it increases the risk denominator for them 150% or more, while a -30% drawdown program is only looking at a 33% increase.

So there you have it, another risk adjusted performance metric for your toolbox, although given the vagaries of that 10% and ability of programs to mask their true risk profile over short periods of time, we prefer to look at the MAR and the all time max drawdown instead of the average.

For more on those equations, here’s a list of posts on the other ratios:

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DISCLAIMER

Forex trading, commodity trading, managed futures, and other alternative investments are complex and carry a risk of substantial losses. As such, they are not suitable for all investors. You should not rely on any of the information as a substitute for the exercise of your own skill and judgment in making such a decision on the appropriateness of such investments.

The entries on this blog are intended to further subscribers understanding, education, and - at times - enjoyment of the world of alternative investments through managed futures, trading systems, and managed forex. Unless distinctly noted otherwise, the data and graphs included herein are intended to be mere examples and exhibits of the topic discussed, are for educational and illustrative purposes only, and do not represent trading in actual accounts. Opinions expressed are that of the author.

The mention of specific asset class performance (i.e. +3.2%, -4.6%) is based on the noted source index (i.e. Newedge CTA Index, S&P 500 Index, etc.), and investors should take care to understand that any index performance is for the constituents of that index only, and does not represent the entire universe of possible investments within that asset class. And further, that there can be limitations and biases to indices such as survivorship and self reporting biases, and instant history.

The performance data for various Commodity Trading Advisor ("CTA") and Commodity Pools are compiled from various sources, including Barclay Hedge, RCM's own estimates of performance based on account managed by advisors on its books, and reports directly from the advisors. These performance figures should not be relied on independent of the individual advisor's disclosure document, which has important information regarding the method of calculation used, whether or not the performance includes proprietary results, and other important footnotes on the advisor's track record.

The mention of general asset class performance (i.e. managed futures did well, stocks were down, bonds were up) is based on RCM’s direct experience in those asset classes, estimates of performance of dozens of CTAs followed by RCM, and averaging of various indices designed to track said asset classes.

The mention of market based performance (i.e. Corn was up 5% today) reflects all available information as of the time and date of the publication.

The owner of this blog, RCM Alternatives, may receive various forms of compensation from certain investment managers highlighted and/or mentioned within the blog, including but not limited to retaining: a portion of trade commissions, a portion of the fees charged to investors by the investment managers, a portion of the fees for operating a fund for the investment managers via affiliate Attain Portfolio Advisors, or via direct payment for marketing services.

Managed Futures Disclaimer:

Past Performance is Not Necessarily Indicative of Future Results. The regulations of the CFTC require that prospective clients of a managed futures program (CTA) receive a disclosure document when they are solicited to enter into an agreement whereby the CTA will direct or guide the client’s commodity interest trading and that certain risk factors be highlighted. The disclosure document contains a complete description of the principal risk factors and each fee to be charged to your account by the CTA.

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Disclaimer

Forex trading, commodity trading, managed futures, and other alternative investments are complex and carry a risk of substantial losses. As such, they are not suitable for all investors.
The mention of market based performance (i.e. Corn was up 5% today) reflects all available information as of the time and date of the publication.